What We Talk About When We Talk About The VIX

The CBOE Volatility Index, or the VIX, is one of the most closely tracked indicators in the stock market.

It's just not exactly what some people seem to think it is.

According to the CBOE's website, the VIX is a, "measure of market expectations of near-term volatility conveyed by S&P 500 stock index option prices."

But when the lack of market volatility becomes the overriding market meme, as it has over the last couple months, the way we talk about the VIX runs into a chicken-or-the-egg problem.

It may seem like markets are complacent or sleepy or calm right now. But as Jonathan Golub at RBC Capital Markets notes, the current "slower for longer recovery" and easy monetary policy from central banks (like the ECB cutting rates last week) is driving this market environment, not the VIX reading. The VIX reflects investor behavior but does not necessarily determine it.

What the VIX really shows is how much traders anticipate the market can move in a given trading session, not really "how complacent" investors are. In a research note today, Golub gives a great crash course in what the VIX really is.

Golub writes (emphasis ours):

"Many market pundits suggest that a weak reading on the VIX indicates complacency. Our work shows that the VIX (3-month implied U.S. equity volatility) is not a fear gauge, nor is it signaling complacent behavior. Rather, the data suggest a decline in realized volatility. This is consistent with more modest daily stock market gyrations. Furthermore, a 10.7 VIX is not unprecedented, having fallen into the 9s in both 1993 and 2007."

When Golub talks about "realized volatility," he's talking about the day-to-day moves in the market and not necessarily bigger market events.

The VIX is called the "fear gauge," perhaps for lack of a better reading for fear than anything else. More aptly, the VIX might be called the "arbitrage gauge," a less sexy term that indicates how many opportunities a trader might have to make money in a given day.

In his note, Golub notes that in low volatility environments, investment managers need to work harder for their "alpha," or performance relative to the benchmark they track. In some ways, volatility makes investors work harder for return, not allowing them take the summer off and play golf as a "complacent" market environment might imply.

Golub notes that while the VIX is at historically low levels, it can still go lower from current levels.

This chart from Golub shows how the VIX stacks up historically:

This chart from Golub shows how volatility moves with the economy into and out of recessions, and drifts lower in the middle of economic recoveries.

Golub believes that lower volatility will lead to multiple expansion - which means the end of the current post-crisis bull market is still out of sight.